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International Reserve Holdings with Sovereign Risk and Costly Tax Collection

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  • Joshua Aizenman
  • Nancy Marion

Abstract

We derive a precautionary demand for international reserves in the presence of sovereign risk and show that political-economy considerations modify the optimal level of reserve holdings. A greater chance of opportunistic behaviour by future policy makers and political corruption reduce the demand for international reserves and increase external borrowing. We provide evidence to support these findings. Consequently, the debt-to-reserves ratio may be less useful as a vulnerability indicator. A version of the Lucas Critique suggests that if a high debt-to-reserves ratio is a symptom of opportunistic behaviour, a policy recommendation to increase international reserve holdings may be welfare-reducing. Copyright 2004 Royal Economic Society.

Suggested Citation

  • Joshua Aizenman & Nancy Marion, 2004. "International Reserve Holdings with Sovereign Risk and Costly Tax Collection," Economic Journal, Royal Economic Society, vol. 114(497), pages 569-591, July.
  • Handle: RePEc:ecj:econjl:v:114:y:2004:i:497:p:569-591
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    References listed on IDEAS

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    1. Elbadawi, Ibrahim A, 1990. "The Sudan Demand for International Reserve: A Case of a Labour-Exporting Country," Economica, London School of Economics and Political Science, vol. 57(225), pages 73-89, February.
    2. Hipple, F Steb, 1979. "A Note on the Measurement of the Holding Cost of International Reserves," The Review of Economics and Statistics, MIT Press, vol. 61(4), pages 612-614, November.
    3. Lizondo, JoseSaul & Mathieson, Donald J., 1987. "The stability of the demand for international reserves," Journal of International Money and Finance, Elsevier, vol. 6(3), pages 251-282, September.
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    5. Ben-Bassat, Avraham & Gottlieb, Daniel, 1992. "Optimal international reserves and sovereign risk," Journal of International Economics, Elsevier, vol. 33(3-4), pages 345-362, November.
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    7. Detragiache, Enrica, 1996. "Fiscal Adjustment and Official Reserves in Sovereign Debt Negotiations," Economica, London School of Economics and Political Science, vol. 63(249), pages 81-95, February.
    8. Alberto Alesina & Guido Tabellini, 1990. "A Positive Theory of Fiscal Deficits and Government Debt," Review of Economic Studies, Oxford University Press, vol. 57(3), pages 403-414.
    9. Vito Tanzi & Hamid R Davoodi, 1997. "Corruption, Public Investment, and Growth," IMF Working Papers 97/139, International Monetary Fund.
    10. Cukierman, Alex & Edwards, Sebastian & Tabellini, Guido, 1992. "Seigniorage and Political Instability," American Economic Review, American Economic Association, vol. 82(3), pages 537-555, June.
    11. Van Wijnbergen, Sweder, 1990. "Cash/debt buy-backs and the insurance value of reserves," Journal of International Economics, Elsevier, vol. 29(1-2), pages 123-131, August.
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    JEL classification:

    • F15 - International Economics - - Trade - - - Economic Integration
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements

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